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Mutual Funds : The Cost Matter Hypothesis

Active investment still has some active defenders, And digging into the reasons for active funds’ persistent problems, it is easy to see why. Despite the claims of the Efficient Market Hypothesis (EMH) that it is impossible to beat the market other than by luck, it appears that an impressive number of managers do achieve the feat.

The problem is that they do not manage to beat the index by enough to be able to pay themselves and still pass on a decent performance to their clients. In other words, to quote Jack Bogle, the founder of Vanguard and the spiritual father of index investing, the case for passive investing rests on the CMH (Cost Matters Hypothesis), not the EMH.

FT published the data beginning of the year from a research consultancy based out in London
“They have completed a survey of how 425 global equity funds benchmarked against the MSCI World index performed last year. According to the official data, some 31 per cent of them outperformed the MSCI World, which gained an impressive 16.5 per cent last year. That is in line with the usual rate at which funds outperform their benchmark, and it is in line with the industry average for last year, showing that Style Research had a representative sample.

But Style Research, looking to see what had driven outperformance, measured the performance of the funds’ holdings, without taking any costs into account. On this basis, 59 per cent of them beat the index. So 28 per cent of the funds had managers who came up with a portfolio that beat the index, but charged too much in fees to be able to allow their clients to beat the index.”

The sheer size that funds with a strong past record can attain will often militate against outperformance. Fidelity Magellan in the US, the first fund to top $100bn in assets, is a good example. Bets on small companies, once a speciality, became pointless in the context of such a big fund.

Of course, index funds are not costless. One regular point made by supporters of active management is that because of their costs, index funds are in fact guaranteed to fail to match their index. Certainly, an index fund with the front-end charges of a normal active fund is an outrageous proposition which nobody should buy. But with the largest exchange-traded funds (ETFs), the tracking error is very low.

So active managers do appear to add real value. They can beat the index. But the costs they incur in doing so render their funds a worse option, on average, than equivalent index funds. Or as Mr Thielmann puts it: “The only conclusion to be drawn from the underperformance of funds is that that the financial industry is very good in extracting money from mutual funds.”

May be I can open the debate here do the Indian Mutual fund manager invest in there own Mutual Funds !!